Adapting Our Approach Toward Growth

Just about all of my clients are long-term, retirement oriented investors.  The most frustrating thing the past few years for long-term investors is how the central banks have largely “killed” the markets in the traditional investment sense.  What I mean by “killed” is that I cannot honestly consider bonds yielding less than 2% and stocks on average trading over 20x earnings (earnings yields less than 5%) as a legitimate long-term “investment” unless you like paltry returns.

The markets today are largely trading mechanisms where it’s better to “rent” than “own for the long run.”  Investors have been buying bonds for appreciation (expecting yields to move lower) and stocks for income.  That’s totally backwards and somewhat scary to think about, but that’s what happens when central banks distort markets.

When I look at stocks, we own a nice basket of quality companies that I do consider long-term investments.  With that said, the list is getting shorter each year and I’ve been trimming the total allocation to stocks as valuations continue to rise.  It doesn’t matter how great a company is, you can still lose money on an investment if you overpay for the stock. 

As the cash continues to build, and with bonds largely not worth owning, I’ve been left in a tricky position.  For the past year I’ve been selling a lot of cash-secured put options to earn some income on our cash while we wait for opportunities but as time goes by, stocks look more and more unattractive making me think that we could be waiting a long time.  So I’ve made the decision to incorporate a short-term trading strategy as part of our Growth allocation (about 20% of the allocation).

I’ve resisted going this route for about a year now but at this point I feel my hand is forced.   I’ve written in past letters to my clients that there remains the possibility we see stocks accelerate to the upside.  As investors feel compelled to “chase yield” in the stock market, and as stocks continue to grind higher, the momentum can attract a lot of money very quickly as people capitulate and feel like they’re missing out with no other place to invest.  These are the conditions that can create huge moves higher in a short period of time (i.e. a bubble).  It’s something we want to ride it if happens while controlling or limiting our risk.  The best way to do that is not to actually own stocks but to have exposure to stocks via options. 

I want to use options because we can limit the amount of money we can lose in the event of a big drop in the market.  A continued advance is not guaranteed, just a possibility, and with valuations near the most elevated levels in history, the risks remain high.  It’s an interesting environment where I would not be surprised by a large move in either direction.  

The strategy I’m going to implement is actually something I developed for myself over time.  It’s purely systematic (rules based) and I’ve backtested it as far back as I can get the data (over 50 years).  Interestingly, while the rules haven’t changed, the returns have improved each decade which I think is due to a combination of central bank intervention beginning in the 1980’s and the advent of other systematic trading algorithms and their effects on price trends, as I briefly wrote about yesterday.  On average, it produces about 1 trade per month (some months 4 or 5, others 0, all depending on how volatile the stock market is) and the time in the trade can last anywhere from 1 day to multiple weeks.  Ultimately this should give us some exposure to some of the short-term swings/rallies in the market without actually risking a lot of money.

The need to innovate and adapt never ends.  Thanks for following!

-Nick